Leap Into Taiwan Semiconductor (TSM) on the Apple Rumors

Big money plowed into TSM on the long side Tuesday -- take a look

Taiwan Semiconductor (TSM) is the largest dedicated semiconductor manufacturer in the world. The Hsinchu-based wafer fabricator produces wafers and logic-chips for many of the most notable names in the tech industry … and it may have acquired a new patron in the form of Apple (AAPL).

Shares in TSM had been lagging behind industry competitors as recently as Monday, but after details of a possible deal materialized the stock rallied hard — it closed Tuesday at $17.53, a gain of more than 5% from Monday’s lows.

Let’s dig a bit deeper and identify an options trade to play for continued bullishness.

The details of the possible deal with Apple have been laid out in reports from such outlets as DigiTimes — the partnership would bring not only short-term profit but also long-term growth potential, and a high probability of a lasting relationship with Apple.

The Cupertino tech giant has long wanted to cut ties with long-term partner (and current chip producer) Samsung (SSNLF) due to the obvious conflicts of interest this relationship creates and the belief that another company could produce chips that would better suit the iPhone and iPad. Taiwan Semi’s 20, 16 and 10nm processing nodes appear to be of greater interest than the 32nm nodes Apple is currently purchasing from Samsung, and may be paired with Intel (INTC) technology in the finalized A8 chips as early as this month.

And the potential deal with Apple is not the bright spot for TSM stock right now. TheStreet.com yesterday reiterated its buy rating on the stock, citing a strong and improving return on equity and impressive year-over-year EPS growth of 18.2% in the most recent quarter. The strength of the company, coupled with growing enthusiasm for semiconductor stocks in general, has allowed TSM to outperform the S&P 500 on a consistent basis.

Though the rumors regarding the Apple deal at this point are just that — rumors — the fab group’s stock continues to tick upward in response to these rumors. A deal with Apple could shore up the reputation of Taiwan Semi (which has taken some flak for inconsistency) and be the basis for a long-term relationship that would allow TSMC to provide robust competition to any industry rivals.

Additionally, the (reportedly) three-year deal would place Taiwan Semi directly alongside Apple in the production of several new iPad and iPhone designs, and allow the company to reap the benefits of being involved with two of the most profitable product lines on the planet. TSM has seen its profit margins shrink over recent quarters — such a partnership would likely bring a welcome reversal of that trend.

The ‘Institutional Trade’

A trader on Tuesday bought more than $4.3 million worth of at-the-money calls in TSM, which piqued my interest and flagged the stock for further consideration. Let’s break down this trade:

A trader bought 19,829 TSM January 2015 17.5 calls for $2.20 each.

Risk: $220 per 1 lot

Reward: Unlimited

Breakeven: $19.70

Cash Outlay: $4,362,380

Greeks of this trade:

Delta: Long

Gamma: Long

Vega: Long

Theta: Short

Click to Enlarge The trade looks good to me — I piggybacked the big institutional money here. Risk / reward profile (and recent stock action) is in the chart at right.

A Note on Our Process

We define unusual option activity as large block trades that represent a large percentage of daily option volume. The block trade is considered “unusual” if the option volume is above the average daily volume over the past 22 days. At KeeneOnTheMarket.com, we scan and analyze order flow from all of the major options exchanges to identify any unusual option activity.

Analyzing unusual order flow gives traders a window into the positions of large institutional players. The majority of unusual option activity can be traced back to hedge funds, mutual funds and other large institutions. Knowing where these institutions are placing their bets can be advantageous for any trader, as they have informational and technological advantages the average trader doesn’t have, and the amount of time and analysis that goes into every one of their trades is substantial. We offer this service through our seven-hour daily live trading room or through our Premium Twitter feed with all entries, exits and unusual options activity tweeted all day long.

However, order flow can be deceiving sometimes. One might logically think that a large buyer of calls is bullish on the underlying security. This is not always the case. Remember that many participants in the equity options market are hedgers. Long calls are a hedge against short stock, and long puts are a hedge against long stock. With this in mind, we have developed a seven-step trading plan that helps filter out unusual option activity that will not provide actionable trade setups. It is by using this plan that we are able to identify the most significant unusual options activity trades every day.

At the time of publication, Keene was long the TSM Jan 2015 17.5 calls.

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